Economists have been virtually universal in their prediction that Chinese inflation would peak this summer — so much so that I’ve felt like a pretty lonely skeptic. As far as I can tell, the forces that have been driving prices upwards for the past 18 months remain essentially unchanged, and are likely to continue.

The rationale usually given for slowing inflation goes like this: China’s central bank, the People’s Bank of China (PBOC), realizes that the Chinese economy is overheating, putting stress on limited available resources, so they’ve been running an ever-tightening monetary policy throughout the Spring. As the policy takes hold, and growth slows, inflation will diminish — bringing the economy in for a “soft landing.” More recently, analysts point to the likelihood of a renewed slowdown in Europe and the United States as an external factor that will further dampen price pressure.

In my view, this story overestimates the amount of monetary tightening that’s really been going on, and underestimates the massive expansion in China’s money supply that initially flowed into asset prices (such as real estate, gold, and commodities) and is only now working its way through the Chinese economy in the form of higher wages, higher housing costs, and higher food prices.

Although the PBOC has consistently raised bank reserve requirements, the effect has only been, at best, to cancel out the expansionary impact of accumulating FX reserves in order to keep the RMB from rising too rapidly. And although these restrictions have reined in formal lending somewhat — bringing reported M2 growth down from 28% in 2009, to 20% in 2010, to a still rather generous 15-16% this year — banks have developed a host of clever new ways to keep the credit flowing. Marginal lenders (mainly private sector entrepreneurs) may find themselves struggling to obtain credit, but borrowers with enough guanxi (mainly SOEs and government-sponsored projects, many of them of dubious economic value) can still easily fund funding at sub-market rates.

Some bank analysts I talked to yesterday estimated that, in addition to the RMB 8-9 trillion Chinese banks are expected to formally lend this year, there is probably another RMB 10 trillion in invisible lending taking place via trusts, private wealth management vehicles, and offshore letters of credit. These “shadow” funds may not exhibit the same multiplier effect on the money supply as formal bank deposits, but even so, the first-order impact (twice as much lending as ostensibly reported) is still huge.

The point is, there’s lots of money out there, and lots more going in. Unless a downturn is severe enough to cause either velocity to collapse (making people want to hold onto piles of cash), or the money supply itself to contract (by forcing banks to call in their loans), all that money sloshing around is going to keep pressing prices upwards. The “soft landing” that everyone is hoping for won’t do that. The worst case is China ends up with stagflation — slowing growth and still too much money — only now, that money is chasing even fewer goods than before. The scenario is made even worse if a lot of that money is flowing into investments (like empty apartments) that count as GDP initially, but don’t produce returns. Again, now you’ve got more money and slower ongoing growth, a dire combination.

So whose picture is right? I’m hoping mine isn’t, but consider the following data points over the past week or so (mainly courtesy of the Bank of America-Merrill Lynch China research team). Keep in mind that everyone says Chinese inflation will peak this summer, and this is the last month for that to happen:

This Sunday (Aug 28) Xinhua, China’s official news agency, reported that the price of spinach is up 31.2% and the price of lettuce is up 27.3% compared to just one month ago. Eggs are up 16.1% compared to a year ago.

Last week, the National Bureau of Statistics reported that edible oil prices across 50 cities had risen by 2.3% in the preceding 10 days. Xinhua says the price of edible oil is now 21.8% higher than last year.

Last week the NDRC (state planning commission) reported that, despite vigorous efforts to control them, pork prices continue to rise. Xinhua said Sunday that pork prices have rebounded and are close to their 1H high.

Last week, China News reported that Chinese farmers expect grain prices to rise, and are reluctant to sell their crops at current prices. Some private grain distributors say that their purchases are 90% down from last year (it’s worth noting that the reluctance of farmers to sell their produce was one of the most serious problems that emerged during Germany’s bout with hyperinflation immediately following the First World War).

The NDRC stated on its website that it expects prices to stay high, and lays the blame (as usual) on global liquidity, surging production costs, and natural disasters.

Clearly the pressure is continuing, and at least some Chinese officials have figured out the reason why. A week ago, no less a personage than Vice Premier Wang Qishan — China’s top economic trouble-shooter for decades — said China must crack down on “illegal financing” in order to prevent a systemic or regional crisis. And yesterday, Xinhua reported that the PBOC has informed banks that it will begin applying reserve requirements to at least some of the money that has been channeled into off-balance sheet lending. According to the Wall Street Journal:

The move sparked a sharp reaction in China’s markets. The benchmark stock index fell 1.4% on Monday, bucking rises elsewhere in the region, and the one-week lending rate rose to 4.39% from 4.06% last Friday.

Bullish investors may not fully appreciate the underlying dilemma — that China can’t keep fueling growth by making bad investments funded by printing (or rather importing) money — but they understand, at least at gut level, the vital role that generous liquidity has played in sustaining the “China story.”

Maybe the Chinese government, faced with persistent inflation, will finally start running a genuine tightening policy. If so, expect more rapid appreciation of the RMB (to give the PBOC room to actually tighten) and a far more serious slowdown than anything we’ve seen (an end to the investment boom that has been driving well over half of GDP growth). Somehow, though, I suspect the pain will be just too great, and instead China will continue shadow-boxing with an inflation that it dare not take sufficient steps to curb. Expect its officials to turn a blind eye, initially, to alternative credit channels, then scurry around desperately trying to close the barn door after the horse has gone.

The real problem: China wants a correction without having a correction. Good luck with that.

I can’t predict what China’s CPI will actually be from month to month, since temporary price shocks (positive and negative) play a role, and especially since the government controls the numbers anyway, and has a lot riding on them. But I see nothing that tells me the story — of rising prices fueled by money creation covering for a lack of meaningful growth — has changed. And summer is almost over.

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Patrick,
I am in your camp as well. Stagflation is a big risk right now. Look at the excess capacity in Chinese industries. Steel, aluminum, PVC, just about any chemicals, solar panels, textiles, shipping, etc, etc. While everyone has been focused on LGFPs, the SOE sector has been building huge capacity over these last 30 months. There is this obsessive desire for volume (and therefore capacity) with a fuzzy notion that market share will equate to shareholder returns. Combine that with wildly optimistic projections and banks who lend based on names not cash flow, who often say “from one pocket of grandpa to another pocket,” you have a significant and malignant problem.
Heretofore, companies have been able to mask the overcapacity with capitalizing everything into construction costs and inventory. But that will soon end as these projects come on stream and the cost of carrying the inventory weighs on SOE balance sheets. You now begin to see SOEs talking about the need for warehouse space and integrating forward into logistics. That is a telltale sign, in my oopinion.
I would love for you to write on this. Just Google “excess capacity China” and look at the various industries covered.

Jim Chanos states “A lot of people are willing to say China will slow down … The really scary thing is if you do the numbers and they cut back on construction it’s not a slowdown, and they go negative real fast…The fact of the matter is if they hit the brakes really hard, the economy goes into reverse. It doesn’t slow … Nobody will say that publicly because it’s unbelievable. But it happens to be the way the numbers work.”

Does that mean that construction is driving all GDP growth, not just half as you claim? After all, he spends a lot of time combing through the numbers, so he should know what he’s talking about.